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Implied Terms and Interpretations in Contract Law

Implied Terms and Interpretations in Contract Law



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Published by: legalmatters on Aug 11, 2007
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George M. Cohen
 Edward F. Howrey Research Professor of Law, University of VirginiaSchool of Law
© Copyright 1999 George M. Cohen
This chapter examines the economic arguments for textualism andcontextualism, the two primary methodologies used by courts to determine theintentions of contracting parties with respect to their performance obligations.Textualism, which is rooted in the idea of complete contracting, calls for amore restrictive approach to implied terms and interpretation thancontextualism, which is rooted in the idea of incomplete contracts. The primaryconclusions are that, as in other areas of contract law, the choice between thetwo interpretive methodologies depends on the transaction costs of drafting, therelative likelihood of court error, and the risks of opportunistic behavior.Neither methodology dominates so much that it should be uniformly employed,which is consistent with how courts actually behave.
 JEL classification:
Contracts, Completeness, Interpretation, Implied Terms,Opportunism, Contextualism, Textualism
1. Introduction
Questions of how courts interpret, and should interpret, contract terms andwhen courts imply, and should imply, terms to which the contracting partieshave not explicitly agreed, loom large in contract disputes and in the legalliterature on contract law. Law and economics scholars, however, have writtenfar more extensively on other topics in contract law than on these questions.For example, Judge Posner’s treatise has no section specifically discussinginterpretation or implied terms, and discusses contractual good faith in onlytwo paragraphs (Richard Posner, 1998, pp. 103, 126). Other leading textbooksalso have no discussion of interpretation or implied terms. One possibleexplanation for this discrepancy is that there is little need for researchspecifically on interpretation and implied terms because much of the economicanalysis of other areas of contract law carries over straightforwardly to these
 Implied Terms and Interpretation in Contract Law
79questions. An alternative explanation is that economic analysis has less to sayabout interpretation methods than it does about other questions in contract law.This article, which will summarize and expand on the literature that does exist,aims to demonstrate that economic analysis has a good deal to say aboutinterpretation questions, but the issues are complex and there are many fruitfulavenues for further research.The argument that there is no real need for a separate economic analysis of interpretation and implied terms stems from the fact that the delineation of thetopic is based on legal rather than economic considerations. In contract law,interpretation usually refers to problems arising from express contract termsthat are reasonably susceptible of more than one meaning. Implied terms arethose that are added to, or place limits on, expressly stated terms. The two areclosely related, yet not identical. For example, if a contract contains a ‘bestefforts’ clause, determining what that clause requires is a question of interpretation; if the contract contains no such clause, courts may have todecide whether to imply a best efforts obligation, and if they do, they have todetermine the content of that obligation. On the other hand, some questions of interpretation do not involve questions of implication, for example, a disputeover the meaning of the word ‘chicken’.In some sense, all contract disputes involve questions of interpretation andimplied terms. For example,
 force majeure
clauses - usually discussed in thecontext of the (implied) impossibility defense - present questions of interpretation, and most contract formation, excuse, and damage rules are‘implied terms’. But contract law has generally used the labels ‘interpretation’and ‘implied terms’ more narrowly, to refer to questions of contractperformance, rather than questions of formation, excuse, defense, or remedy.That is, the legal issue addressed by these doctrines is whether one or moreparties have performed as the contract requires, or have breached. Thus, I willassume for purposes of this discussion that the parties have made anenforceable contract, there are no changed circumstances or ‘mistakes’sufficient to give rise to an excuse claim, the applicable remedies in the eventof breach are accepted, and there are no third-party effects. How do courtsdecide - and how should they decide - what the performance obligations are andwhether the parties have met them?
2. Complete or Incomplete Contracts
Economic analyses of contract law have tended to start with the idealizedconcept of a ‘complete’ contract, though this term has perhaps engenderedmore confusion than clarity. Traditionally, a complete contract has referred toone that provides a complete description of a set of possible contingencies and
 Implied Terms and Interpretation in Contract Law
4400explicit contract terms dictating a performance response for each of thesecontingencies (Al-Najjar, 1995; Hart and Moore, 1988). Contingencies includechanges in ‘exogenous’ economic variables, such as a production cost increase.But they also include ‘endogenous’ behavioral responses, such as falselyclaiming a cost increase or seeking refuge from a now-disadvantageous bargainbehind a contract term intended to serve a different purpose. Economic analysesgenerally conclude that if a contract is complete, there is no beneficial role fora court other than to enforce the contract according to its terms; that is,incompleteness is a necessary, though not sufficient, condition for an activecourt role in interpretation and implied terms.But because no real-world contracts are fully complete in this sense, theconcept of completeness does not get us very far. The concept can be rescuedin one of three ways. One way is to view completeness as a useful benchmark,similar to perfect competition. Just as some markets are close enough to beingperfectly competitive that the perfect competition model is a useful predictor,so some contracts may be complete enough that no reasonable interpretation orimplied term questions arise. The law refers to these contracts as ‘integrated’.But tying completeness to integration simply reduces to a tautology thestatement that a complete contract obviates the need for interpretation orimplied terms. The question is how do courts know when a contract is completein this sense.One way courts can know a contract is complete is if the parties tell them.Thus, a second way to rescue completeness is to recognize that contractingparties can make a contract complete by using general ‘catchall’ clauses thatstate what happens in all unspecified states of the world (Hermalin and Katz,1993, p. 236; Hadfield, 1994, p. 160, n.5). For example, a catchall clause mightstate: ‘The price term will be x, and will apply regardless of any change incircumstances or conduct by either party’. Alternatively, the parties could statetheir general desire not to have courts interpret or imply terms. But althoughcontracting parties often use general clauses such as merger clauses, whichdirect a court to apply a particular interpretive methodology (that is, do not look beyond the writing), they do not seem to use catchall clauses that are broadenough to make contracts complete. Of course, clauses that are not stated ascatchalls could be - and sometimes are - interpreted that way, but, to lawyersat least, if not economists, that act of interpretation then requires justification(Hadfield, 1994, p. 160). Even clauses that are stated as catchalls might requireinterpretation (Charny, 1991). Moreover, contracting parties often usecontracting clauses that are the exact opposites of completeness catchalls:general clauses such as ‘good faith’ or ‘best efforts’ clauses signal contractingincompleteness, as opposed to completeness (Hadfield, 1994, p. 163).A third way to rescue completeness, more common in formal economicmodeling, is to tie the concept of completeness to the efficient use of available

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